Analysis of developments in financial markets, economics and public policy geared towards anyone with a stake in these issues......and, yes, we all have one.

Saturday, January 19, 2013

A Slide in the Dollar: A Sign of Confidence Or Harbinger of a Grim Future?

When scanning financial markets data looking for any
curveballs that the nascent year may have thrown our way, one’s eyes tend to
hone in on recent moves in the currency market. What stands out is how the
beleaguered Euro is now worth $1.33, its highest level in nearly a year. This rise stands in contrast to market
forecasts predicting the EUR dipping against the USD over the course of 2013. In
truth, the move began last summer with the ECB’s July statement that it would
do “whatever it takes” to ensure the survival of the single currency. Since
then, the USD has lost 9.3% of its value vs. the Euro. In dealing with these
two flawed….in the macroeconomic sense….currencies, one must decipher whether
it is an issue of EUR strength or USD weakness. To partially answer that, we
can look at the USD index, which is based on a basket of currencies from six
major advanced-markets. During the same period this index (DXY) has dipped
4.7%, granted much of it owing to the EUR’s large weighting within the basket.

All of this is likely a bit abstract for those not chained
to a trading terminal and espresso machine the whole day. But such movements in
the FX market provide insight into a country’s economic condition and also give
clues on developments in other asset classes such as equities and government
bonds.

Tossing in the Wrench

In the textbooks, the value of free-floating currencies
should be set by a country’s level of trade, demand for its financial products,
and investors’ perception of its macroeconomic condition with regard to growth,
inflation and interest rates. Of course in extraordinary times all these
factors can get overwhelmed by the actions and words of a few high level
government and central bank officials.
Mario Draghi’s unequivocal support of the Euro is one example, removing
(for now) the risk premium that the currency would eventually vaporize. Only
two months later, the U.S. Fed announced QE3 to the tune of $85bn in monthly
asset purchases. Not to be outdone, Japanese officials recently gave a serious
shout-down to the Yen, which has seen that currency plummet nearly 14% vs. the
USD since September and 21% vs. the Euro (since July). This move has undoubtedly caused elation among
Japanese exporters, making their products cheaper on the global stage. The
southward drift of the USD has equally ameliorative effects for the U.S. trade
balance and also has the added benefit of kicking foreign bondholders in the
teeth by diminishing the future value of their holdings. The recent rise in the
Euro, has begun to sound alarm bells as more expensive exports would add yet
another hurdle to the region’s anemic growth. Austerity has already scarred the
economic landscape, leaving trade as one of the few remaining straws upon which
to grasp. Any time there is so much
action, real or perceived, to depreciate a currency, the detrimental concept of
beggar thy neighbor arises, which
inevitably distorts normal trade flows, global economic cooperation and ultimately
growth.

High on Its Perch….As
in the Past Were Louis XVI, General Custer and Lance Armstrong

The U.S. has had a pretty good thing going for quite a
while. That thing is the fact that
the dollar acts as the world’s reserve currency. Yet, all good things must come
to an end. Not that there is an imminent dollar crisis on the horizon, but the
country’s chronic fiscal imbalances are becoming ever harder to ignore. As
evidenced by the fiscal-cliff fight (which solved nothing), markets are eager
to learn how the federal government can cull its debt ratio of 100% of GDP and
better match revenues to ever-growing outlays. Until now, there has been continued demand for
U.S. Treasuries, namely from the buyers down the street at the Fed. The central
bank’s purchases are purportedly for kick-starting the economy, but the
elephantine balance sheet, which has ballooned to nearly $3 trillion, has
lowered interest rates sufficiently to allow the government to finance its
obligations on the cheap. Unfortunately, as seen in the second chart, those
newly created funds have not found their way into circulation and thus into
wages or rising corporate sales.

Vacancy at the Safe
Haven Resort

Even without Fed intrusion…..I mean participation….in the
Treasury market, the U.S. reaps advantages from its position as the world’s
largest economy and the role the USD plays in it. If U.S. growth is outpacing
other parts of the word, all things being equal, the greenback should
appreciate. This is a consequence of the aforementioned demand increase for
U.S. manufactured goods and financial assets like equities. Should the global
economy (including the U.S) hit the skids, then the USD’s value should….get
this….rise in this situation as well.
The reason is the role Treasuries play as the world’s favored safe-haven
investment. When bond demand goes up in tumultuous times, the dollar follows
along, as investors need the greenback to facilitate Treasury purchases.

The table seems set for the latter (sluggish growth)
scenario for 2013. Just this past week the World Bank lowered its global growth
forecasts to 2.4%, with developed markets registering only a 1.3% expansion and
the Eurozone mired in negative territory. As seen below, the IMF, despite a
higher top-line number, expects a similar path.

Given the curtailed expectations, it is curious to see the
USD lose ground over the past two months (it had rallied on the QE3
announcement through much of the early autumn). Similarly, other safe-haven
currencies have sold off of late. The Yen, thanks to Bank of Japan’s asset
purchases and stance of the new Abe government, and also the Swiss Franc. After
holding its value at CHF 1.20 to the EUR for an extended period (printing
Francs to combat appreciation) the currency has now drifted to the lower level
of CHF 1.245. As is the case with the other countries, the weaker Franc is
welcome news to Swiss exporters. In such a low growth environment, one would be
forgiven if he expected each of these currencies to rise. Instead we get a
lesson on the power of non-market forces in influencing currency pricing.

Cheap Gas, Pricey
Cheesecake

Another slice of economic data hitting the wires this past
week, which may cast light on USD movement, is the release of December’s
inflation data. As seen in the chart below, the core data (excluding things we
actually use like food and energy) drifted south throughout 2012 and is well
beneath the Fed’s newly proclaimed comfort limit of 2.5%. The good news
continues in the headline number with energy costs, namely gasoline, having
receded; the downer is that food costs have advanced three months running.

Without upward price pressure, the Fed sees little reason to
dial up interest rates anytime in the remote (using the term very loosely)
future. And with returns on Treasuries and other USD-denominated assets so
meager, it is no surprise that the USD continues to drift lower as higher
yielding alternatives are available in the marketplace….much to the chagrin of
emerging market finance ministers. At some point, however, such relaxed
monetary policy may come back to haunt authorities, especially as the steps
identified to sop up excess liquidity remain either untested or, as with the
case with raising interest rates, risks thwacking the entire economy. Ironically,
rising rates should be USD positive, but if the Fed gets behind the curve on
containing inflation, then investors will fear a haircut to the future value of
their USD-denominated assets. And during this entire time, as concerns over
government finances simmer…..or boil over…..the market will look for
alternatives to the dollar. The Euro has eliminated itself from competition for
the time being and the Swiss Franc is too illiquid, but more stable,
free-floating EM currencies and of course gold, may prove viable choices.

And Gold’s Opinion on
the Greenback?

As seen in the chart above, gold in USD terms has dipped
5.2% since the end of September. This is another way of saying that the USD has
strengthened relative to the yellow metal, inferring greater investor
confidence in the buck. During the same period, the EUR has rallied a more
impressive 8.4% vs. gold. With the EUR, this is likely yet another relief rally
in its ongoing debt saga. Concerning the USD, given that both it and gold are
considered relative safe-havens with the latter acting as an additional hedge
against U.S. inflation (USD weakness), the fact that the greenback is stronger
in gold terms yet weaker by nearly every other measure reflects a mix of ho-hum
global growth, relative stability compared to macro fiasco of the past few
years and subdued domestic inflation.

Rotation into Risk,
Or Something More Sinister?

It is quite easy to overthink reasons why the USD has dipped
of late. One never knows which of the myriad factors has the edge in the multidirectional
tug-of-war. Recent weakness may simply be attributed to the fact that risk
assets are currently on a roll and the black & white risk-on / risk-off
trade may still be intact. In that situation, the USD dips anytime investors
dial up their exposure to equities, commodities and the like. On Friday, the
S&P 500 closed at 1485.98, its highest level since November 2007 and is
only 5.1% off its record high from earlier that autumn. Since its most recent
mini-swoon in October, the SPX has gained 9.8%.

Evidence of the inverse relationship between the USD and
shares is illustrated in the chart below. For much of the latter half of 2012,
the inverse correlation grew stronger as investors rushed into the USD and out
of shares as the one-two punch of the Eurozone crisis and disappointed EM
growth dented confidence.

As expected, the recent rally has also seen a sell-off in
Treasuries, with yields on the 10-year rising 28 bps since December. The move
away from Treasuries and into stocks….with early year investment fund flows
finally following along….is a move that would typically be accompanied by a USD
sell-off. If that is the case, then great; the Fed’s goal of pumping up asset
prices may finally live up to the hype and may even lead to a wealth effect. But as time goes on, without
real validation of the policy via higher corporate revenues and improved
employment, the potential of these extraordinary measures stirring up inflation
may set in stone a more structural downward path of the USD.

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About Me

During my career as an investment analyst, several developments from the realms of financial markets, economics and public policy struck me as highly relevant, not to me in my role as a market observer, but in my role as a citizen. The subjects covered on these pages are not aimed at fellow investors or policy junkies, but to the broader population, which needs to recognize the shifts occuring in the economy and understand their consequences, as well as those of government policy.